Emerging Markets/International Stocks

The China Syndrome Revisited or Beware of the Whipsaw

The China Syndrome was the title of a 1979 movie starring Jane Fonda about a fictitious nuclear power plant meltdown.  The name comes from the wildly exaggerated notion that a meltdown at a nuclear plant could eat right through the center of the earth and damage a country on the other side of the globe, namely China.  Perhaps what we have experienced this past month in the stock market should be referred to as a “reverse China Syndrome” – a meltdown in Chinese markets that has reverberated right through the earth to bring down markets on the other side of the globe – namely the U.S. and Europe.

Whatever name you want to give to it, the recent market volatility raises two important questions: 1) What is really going on in China and what effect will it have on the U.S. economy, markets and companies? (Okay, maybe this is really more than one question, but we’re going to treat it as one.)  And 2) How should it affect your investing strategy?

The first question is difficult to answer simply.  Our best guess is that the current economic and stock market gyrations are ultimately a result of the Chinese government’s attempts to control market forces and manage the country’s economy.  The Chinese government has done a pretty good job of it over the last couple of decades, but market forces tend to be very powerful and unwieldy things, and you can only control them for so long.  Just ask the leaders of the old Soviet Union.  Because the Chinese government has been more willing to acknowledge the power and usefulness of market forces than were their comrades in the Soviet Union, we don’t expect the current bumpiness in the Chinese economy to lead to the kind of upheaval we saw in Russia 25 years ago.  But neither do we think the Chinese will be able to go right back to “business as usual” either. 

The effect on economies, markets and companies outside of China will vary dramatically depending on where you look.  In recent issues we have examined the carnage in the mining and natural resources sectors, and much of that can be traced back to China.  Various Chinese policies led to a spike in demand for energy, iron ore and many other raw materials over the last decade or so, and this caused many producers of these materials to increase capacity.  Now the Chinese are being compelled by market forces (for example, you can only keep on stockpiling unneeded steel for so long) to cut back their demand, which is causing supply gluts in many materials.

Fortunately, the U.S. economy is sufficiently strong that the effects of the fall in Chinese demand are not likely to be felt broadly.  Sure, coal, iron and steel producers, and a variety of other discrete industries may suffer, but a number of domestic forces – a reasonably strong consumer, lower energy prices and a housing rebound to name just a few – will keep our economy chugging along.  This may not be the case, however, in many emerging markets where natural resources make up a much larger part of the economy.

Notwithstanding our views on the strength of the U.S. economy, we don’t think we’ve seen the end of the volatility in the U.S. stock market related to China.  Investors love to worry about something, and there is likely to be plenty of worrisome economic news out of China for the foreseeable future.

So this leads to the question about how all this should affect your investment strategy.  Our answer is “only very minimally.”  As we discussed last month in our article about coal, there will be sectors where the decline in Chinese demand could significantly postpone or possibly even eliminate the likelihood of stock price rebounds.  However, right now we don’t see any such sectors outside of natural resources and metals.

Most importantly, we believe that it is very important not to let the market volatility spook you into bailing out of stocks or taking other similar drastic action.  While it may be painful to ride out a sharp downturn, that is the best strategy.  The market will recover from any of these downdrafts, usually quite quickly.

To test this thesis, we went back about six years to look at all of the months during which the S&P 500 dropped more than five percent from the previous month’s close.  This has happened 11 times since the beginning of 2010, not including this past month.  As the chart to the right shows, in nine of those instances the S&P regained its pre-fall level in two months or less, and in no instance did it take more than five months.  The one prolonged slump during this period occurred in 2011, running from late April into November.  Even then, the S&P had regained its April 2011 high by mid-February 2012.

To be sure, there are occasionally market downturns that can last a long time.  When the market turned south in mid-2007, it did not fully bottom out for 16 months, and it took almost six years to regain its 2007 highs.  But that was one of the worst downturns in history.  Moreover, even if you bought in at the absolute pre-crash peak in 2007, you would still be 25% better off today – and that is afterthis past month’s meltdown.  And if you had bailed out at the market’s low in March of 2009, you would have missed out on an almost 200% rebound

With the market so likely to rebound in fairly short order, if you bail out when things begin to get bumpy, you are likely to miss the rebound entirely.  Unfortunately, many investors who do bail out at the first sign of trouble finally build up their courage and get back into stocks just as the market peaks and heads for another dip.  This is known as “getting whipsawed,” and it is very detrimental to your financial health.

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